A fierce debate is underway in Germany on the Target-2 balances, the intra-euro area settlement accounts. Those playing down the importance of these balances are not presenting very convincing arguments.
Target-2 claims of the Deutsche Bundesbank, amounting to more than €900bn, constitute nearly 30% of German GDP; similar to the foreign reserves position of China (28% of GDP). China is exposed to US government bonds, but its reserves are marketable assets that are paying interest and have a due date. By contrast, the interest rate on Target-2 claims is currently zero, and the claims have no due date and no upper limit. Although the event of a member country exiting the euro may seem improbable, the potential financial consequences for the rest of the currency bloc are certainly not marginal.
Hans-Werner Sinn stands out among the protagonists in the debate. The former president of the Munich-based Ifo Institute for Economic Research has reiterated that the Bundesbank’s Target-2 claims are highly risky. He stressed that this is not only risky in the event of a full or partial euro area breakup, but also if the currency union remains intact. Individual countries will find it increasingly difficult to service interest payments on the Target-2 liabilities when the European Central Bank’s main policy rates rise. In present value terms, a national central bank could become internally bankrupt when its target liability exceeds its share of expect future seignorage payments, plus equity.
Several economists have challenged this view. Martin Hellwig, director of the Max Planck Institute for Research on Collective Goods, has said the refinancing operations of national central banks and the assets accepted under the common monetary policy framework, rather than the Target-2 balances, should be the centre of attention. In his view, the Bundesbank is a hybrid national and supranational institution that cannot clearly be included in an analysis of national welfare of Germany.
Marcel Fratzscher, president of research institute DIW Berlin, has stressed the insurance function of the Target-2 system and the potential damage to Germany’s banking sector if the balances were capped or limited in any way. He highlighted that Germany has a gross stock of €3tn in foreign assets within the euro area, which are effectively protected by the Target-2 system. In his view, there is zero risk associated with Target-2 imbalances.
Both counterarguments are unconvincing. While liquidity provision by national central banks is indeed a key concern, it is not only the implementation of a common monetary policy, including quantitative easing, that drives target balances. The last wave of capital flight from Italy in 2016-17 was fuelled by the government’s decision to authorise additional liquidity support measures for the national banking system. These included government guarantees on newly issued bank bonds that were used as collateral when troubled banks borrowed from the Banca d’Italia. The refinancing credit was converted almost instantly into Target-2 liabilities when the money was wire-transferred abroad.
The insurance function of the Target-2 system, although it provides short-term stability for banks, is no longer a convincing argument either. Ten years have passed since the collapse of Lehman Brothers, and seven years since Greece lost access to financial markets. In this longer-term perspective, a liquidity shortage can no longer be the source of the problems. Furthermore, not only Germany but also the crisis countries have accumulated considerable gross foreign assets. In a crisis it is hard to communicate to the public why these assets should not be used to redeem the debt before central banks and ultimately taxpayers get involved.
This topic, so far debated mostly by academics, is entering the political sphere. Wolfgang Steiger, secretary general of the Christian Democratic Union’s economic council, has picked up Sinn’s line of argument. Bundesbank President Jens Weidman largely shares the position of Fratzscher and Hellwig. Weidmann made an interesting statement in a recent interview, saying that if a country should exit the euro, he expects the Target-2 balances to be settled in full. Under this assumption, the positions would indeed be less risky from the Eurosystem’s perspective. But they undoubtedly would lead to conflict once a country steps outside this system.
Target-2 balances are likely to rise at least as long as the ECB maintains its bond-buying programme. The interesting question is what happens after that. Possibly not much, as the ECB intends to replace the maturing bonds. Markets should therefore not be surprised if Target-2 imbalances remain high over an extended period.
Frank Westermann is Professor of Economics at Osnabrück University.